India’s Reforms Creating Unrest
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In April Standard & Poor’s downgraded India’s credit rating. This was followed by Fitch in June dropping India from ‘stable’ to ‘negative’. Both agencies gave similar reasons; rampant corruption and lack of reforms. After achieving annual GDP growth of 8.4% in 2011, the economy is likely to grow just 5.4% this year. Indian politicians, including the Finance Minister Pranab Mukherjee, were on the defensive on S&P’s downgrade and have been quick to reject Fitch’s assessment. However, it served as a rude awakening for policy makers, another drop in ratings to ‘junk’ could seriously damage the government’s popularity and ability to finance its budget deficit.
Furthermore, with the elections scheduled for 2014, the ruling Congress Party would prefer to have strong financial numbers on the table. In what are being dubbed as the boldest economic reforms in more than two decades, the Indian government changed foreign ownership rules in a number of important industries:
- Foreign airlines to purchase up to 49% stake in local airlines,
- Foreigners can now invest up to 51% FDI in multi-brand retail stores
- Foreign investment of greater than $100 million and can open stores in cities with populations exceeding 1 million.
- They raised the FDI cap in broadcasting from 49% to 75%.
As far as the retail sector goes, the states and union territories will make their own decision on allowing FDI.
Frankly these reforms are at least six months too late, if not sooner, and should have been implemented then the Rupee began sliding against the U.S. Dollar in March. Deteriorating market conditions have now made India less attractive for foreign investors.
The once lucrative Indian airline industry is struggling. India’s largest carrier by market cap, Jet Airways reported a loss of $231 million in 2011. Similarly Kingfisher and Spicejet have recorded large losses this year.
The hike in prices of aviation turbine fuel (ATF) won’t help matters and has made the Indian airline sector even less attractive for foreign investment. Where the international average for ATF expenses is 20%-25% ATF of operating costs, it constitutes 45%-50% in India. Since the beginning of 2011, Kingfisher has seen the biggest drop of 80.2% and Jet Airways the smallest of 51.8%.
This turmoil, however, has not deterred Boeing (NYSE: BA) who expects to greatly expand their business in India. High fuel costs due to a weak Rupee will eventually sort themselves out and Boeing expects that India’s share of the global airliner market will rise from just over 1% now to more than 4% by 2030.
However, India is the world’s second most populous country with a growing middle class which makes it attractive to multi-nationals. Earlier this year, President Obama called on India to open its retail doors to foreign firms. The U.S. has done a lot of arm-twisting behind the scenes due to India’s very public defiance over U.S. sanctions against Iran.
A week after the announcement on reforms, the world’s leading retailer Wal-Mart (NYSE: WMT) announced that it will open its stores in India within two years. They had obviously avoided this market due to being unable to control the direction of the business. Now with foreign majority ownership available they will execute on plans that have been likely brewing for years. Wal-Mart is already discussing a partnership with Bharti Enterprises that operates its Easy Day retail outlets across India.
Singapore Telecom (NASDAQOTH: SGAPY.PK) and Bharti Airtel immediately announced an IPO of Bharti’s tower subsidiary and reshuffled the board of directors to make SingTel’s 32.3% stake in both companies explicit voting blocks. While SingTel’s expansion into India has been troubled with low revenue growth to this point, this move signals their willingness to expand their infrastructure in the country. Singapore and India, at a diplomatic level, have been in talks all year on a number of strategic trade issues. India needs the capital of the largest telecom carrier in the region. Players like SingTel, Wal-Mart and Boeing making their moves immediately speaks to their influence in the policy discussions and why these particular industries were opened up versus others.
Although the government’s decision to open the retail sector-- growing at 7.5% annual rate and is expected to achieve $725 billion total sales in five years-- to greater FDI might look lucrative to foreigners the reality is that it is highly unpopular. Indian opposition parties have condemned the PM’s decision alleging that the move is aimed to please President Obama at the expensive of local mom-and-pop stores. A massive strike was organized by opposition BJP and Communist parties in India to protest these retail changes and the 14% diesel price hike. What followed was the closure of offices and businesses across the country at an estimated cost of $2.3 billion.
The government’s ally, Trinamool Congress party, after observing the public rage, decided not to support the decision. Because of this and the states retaining regional licensing power, Wal-Mart will not get permission to operate in BJP dominated or anti-congress states. So far, just 9 out of 28 states have opted to open their retail sector to foreign investors.
Even after the reforms, are still more restrictive than in other emerging markets. In Thailand and Indonesia foreign investors are allowed 100% ownership in retail, yet Wal-Mart has not announced plans to return to Indonesia after leaving in 1999.
The WisdomTree India Earnings Fund ETF (NYSEMKT: EPI) looks like a smart play for bottom feeders. We have likely hit close to the blood-in-the-water moment for India. EPI is only 25% exposed to financials and more than 20% exposed to energy stocks, which will benefit greatly from lowering the diesel subsidy. Refining margins are thin on the best of days, and subsidies only make things worse. Alleviating that stress will free up capital up and downstream the entire energy sector.
Therefore, it is still uncertain whether the changes in policy reforms will have the government’s intended impact on the economy. From the opposition that the government has faced so far, it is clear that the new policies will not be implemented across all the Indian states and union territories. But, these changes, as mild as they may be, were absolutely necessary, especially the reduction in the diesel subsidy. The government is still attempting to avoid real structural reform by inviting foreign investment to cover their inability to alter the shape of their expenditures.
Currently S&P’s rating for the country is BBB-, which puts it below the debt of Spain and Italy, but those ratings are being held high for political reasons. If those ratings reflected reality a number of major U.S. and European banks would have to scramble to improve their risk profiles. Any further decline could result in a flight of capital from the country. The reforms will have some impact positively on fiscal deficit, which is 5.8% of GDP but they do not address the core problems of deficit spending and a chronic current account deficit. But the process is beginning and with a potential global recession in 2013 on the horizon, we may be close to the bottom for India as political change has to lead economic change.
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